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Commercial Real Estate Displays Signs of a Maturing Cycle

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What an eventful year 2017 has been! We weathered winter snowstorms, summer record heat, strong hurricanes and 500-year floods. We watched as campaign promises have gotten mired in legislative tall grass. We cheered as consumers found more jobs and higher wages, only to see those wages outpaced by steeper housing costs. We listened intently as the Federal Reserve announced its plan to unwind its monetary easing by shrinking the assets on its balance sheets. We watched as equity markets met these and other events with optimism by hitting new highs. And the year is not over yet.

Commercial Investments Remain Bifurcated

For commercial real estate, the year witnessed evolving fundamentals. Demand for space remained solid across the core property types, leading to continued declines in vacancies. Even as new supply picked up the pace, rent growth advanced. However, markets are displaying signs of a maturing real estate cycle.

Despite rising cash flows, investors have taken a significantly more cautious approach to commercial acquisitions. On one hand, with the Fed tapering its quantitative easing, investors expect interest rates to rise over the medium term. On the other hand, the gap between what sellers expect to receive and what buyers are willing to pay has grown wider.

Investment sales in large cap markets declined in the first half of 2017 (H1.2017). The volume of commercial sales at the upper end totaled $211.1 billion in H1.2017, a 9.3 percent year-over-year decline, according to Real Capital Analytics (RCA). The yearly investment volume declines were sharper for portfolio and entity transactions, which declined 12.5 percent and 55.1 percent, respectively. Individual transactions slid by 6.3 percent from the first half of 2016. Mirroring underlying shifts in market trends, sales of apartment and retail properties posted double-digit declines during the first six months, while office transactions inched down a slight two percent. Riding favorable trade activity and robust e-commerce demand, industrial properties proved highly attractive for investors, with sales posting a 10.0 percent year-over-year gain.

In contrast to the sales declines in large cap markets, commercial real estate investment in small cap markets–where a majority of REALTORS® is active–regained its upward momentum by the midpoint of the year. Sales volume in REALTOR® markets returned to an upward trend after the first quarter's slide, advancing 4.4 percent in the second quarter, based on data from the National Association of REALTORS®. In addition, a larger percentage of REALTORS® reported closing transactions–75.4 percent, compared with 61.0 percent in the first quarter–a sign of growing activity.

Pricing Flattens

While investment trends bifurcated along deal values, pricing trends moved in concert in both large and small cap markets during the first half of the year. Cap rates have been at historic low levels, with those in markets tracked by RCA averaging 6.9 percent during the period. Cap rates in large cap markets have flattened over the past few months, and are unlikely to contract further given the tightening monetary policy. Pricing data from RCA's Commercial Property Price Index registered a 6.0 percent gain in the first six months, with most of that driven by advances in office and apartment properties.

Other commercial real estate price indices offered similar trends. The Green Street Advisors Commercial Property Price Index–focused on large cap properties–was flat, with a 0.1 percent gain on a yearly basis during the second quarter, at a value of 125.8. The National Council of Real Estate Investment Fiduciaries (NCREIF) Price Index increased 6.3 percent year-over-year in the same period, to a value of 270.7.

In small cap commercial markets, REALTORS® reported that the shortage of available inventory remained the number one concern, and counted as the main driver of price movement. Prices for commercial properties increased 6.7 percent by the midpoint of the year compared with the second quarter of 2016. However, capitalization rates changes mirrored broader trends, rising 30 basis points to an average of 7.3 percent in the second quarter of the year. Not surprisingly, due to the tight inventory, the gap in pricing between buyers and sellers weighed on REALTORS®' markets, ranking at number two of top concerns.

Outlook

As the economic underpinnings advance at a moderate pace, commercial fundamentals are expected to maintain an upward trajectory. With employment in business and professional services still driving growth, demand for offices should remain solid. The industrial sector continues to ride the tail winds of trade and e-commerce. Even as store closures have dampened the outlook for the retail sector, demand for space is likely to continue, driven by consumer spending and changing shopping patterns. Multifamily properties benefit from a double-dose of boost–rising household formation and a shortage of residential housing–which will keep vacancies in check, even with rising new supply.

On the investment side, the slowdown in sales volume in large cap markets during the past year and a half points to stabilization and a maturing of the current cycle. Price growth in large cap markets is slowing down and likely to flatten over the coming months. While small cap market lag their larger counterparts by about three years, the general trends are likely to trickle down over the medium term.

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